Market Commentary | January 21, 2020

Will Europe Lead In 2020 As 2019 Risks Fade?

Will Europe Lead In 2020 As 2019 Risks Fade?

Key Points

  • The receding risks posed by Brexit and the trade wars should provide a tailwind to Europe’s economy.

  • European economic data is improving relative to economist estimates at a pace not seen in years.

  • There is some risk that sequels to trade wars and Brexit could cause pressures to reemerge later this year with the potential to undermine the Eurozone’s improving economic momentum.

Brexit and the U.S.-China trade war weighed heavily on Europe in 2019; these pressures are now easing as 2020 gets underway. December’s U.K. election win by the Conservative party and the announcement of a U.S.-China “phase one” trade deal have greatly diminished risks of a no-deal Brexit or trade war escalation in 2020. These developments may lead to an early spring for Europe, relative to other economies, as the green shoots of growth reemerge.

Three reasons

The receding risks posed by Brexit and the trade war should provide a tailwind to Europe’s economy this year for three primary reasons: 

  1. the U.K. is a big customer of European companies, 
  2. European nations are the among most dependent on trade, and 
  3. Europe may gain the most from the resulting manufacturing rebound.

Let’s look at each of these three reasons Europe may be the biggest beneficiary of the receding risks.

First, outside the United Kingdom, Europe has alot to gain from Brexit avoiding a disruptive outcome since the U.K. is a large customer of European goods. The U.K. has a 66 billion pound trade deficit with the European Union (EU). To put that in perspective, that is three times the size of Europe’s trade deficit with China. Within the EU, the U.K.’s largest trade deficit is with Europe’s largest economy, Germany, as you can see in the chart below. A considerable portion of Germany’s manufactured goods head to the U.K., including 14% of the cars it makes.

U.K. trade balance with other EU countries in 2018

UK trade balance with EU countries

Source: Charles Schwab, Data from U.K. Office for National Statistics’ Pink Book Oct. 2019 Table 9-3.

Second, Europe may be the biggest beneficiary of the global trade truce. More than half of the revenue of companies in the MSCI Europe Index comes from international trade (outside of Europe), according to FactSet data. Specifically, German companies get 79% of revenue from international trade compared with 44% for Japan, 38% for the United States and just 7% for China, as you can see in the chart below. As a result, a rebound in global trade may disproportionately benefit European companies.

European companies rely heavily on foreign revenues

Percentage of company revenue from intl trade

Weighted average for companies in MSCI AC World Index.
Source: Charles Schwab, FactSet data as of 1/10/2020. 

Third, Germany has the most manufacturing-driven economy of the Group of Seven (G7) countries, tying with Japan. Receding trade risks are contributing to a rebound in global manufacturing, which after a long downturn may benefit Europe. Despite France’s low exposure, the overall Eurozone member nations are much more exposed to a recovery in manufacturing than their North American counterparts, the U.S. and Canada.

Manufacturing recovery

G7 table

Source: Charles Schwab, World Bank most recent annual data as of 12/31/19.

Signs of recovery

Due to the heightened exposure to the risks of Brexit and the global trade war, the Eurozone led the way during the recent global economic slowdown. Real GDP growth was at 2.7% in 2017, slowing to 1.9% in 2018, and likely grew just 1.1% in 2019, according to Bloomberg-tracked consensus estimates. But, after roughly two years of declining momentum, signs are emerging that economic growth may have bottomed. The reversal of risks combined with monetary and potential fiscal stimulus may support a recovery in 2020.

The most compelling signs of a turnaround have come from leading indicators in the form of business, economist, and investor surveys:

  • Following a 19-month downturn, the German IFO business climate index started a rebound in September with four back-to-back months without a decline, marking the longest winning streak since early 2017. The IFO survey of business leaders in manufacturing, construction, wholesaling and retailing has a 25 year track record of successfully marking turning points in Eurozone economic output.
  • The Eurozone manufacturing purchasing managers’ index has stabilized after appearing to bottom in September.
  • The ZEW survey of economists’ expectation for the Eurozone economy has rebounded to its highest point since March 2018.
  • After a near two-year downturn, the Sentix investor survey of Eurozone economic conditions has rebounded sharply since October, hitting the highest level in over a year in January. 

It isn’t just sentiment, actual European economic data is improving relative to economist estimates at a pace not seen in years. The better-than-expected data has helped boost Europe’s economic surprise index to rise to its highest level in nearly two years, with European economic data widely exceeding economists’ expectations. The turnaround in economic data has helped lift the MSCI Europe Index back to within one percentage point of the all-time high set in 2000. Historically, economic surprises tend to align with movements in European stocks, as you can see in the chart below.

Europe’s stock market and economic surprises

MSCI Europe Index vs Eurozone Economic Surprise Index

Source: Charles Schwab. Bloomberg data as of 1/13/20. Past performance is no guarantee of future results

The Eurozone slowdown over the past two years has been driven primarily by weaker exports weighing on manufacturing. In contrast, domestic demand has held up relatively well. European retail sales continue to grow at a solid pace, with consumers’ incomes supported by the lowest unemployment rate in over a decade. While manufacturing has struggled, the services sector has continued to expand. If trade and manufacturing rebound, the recovery in Europe’s economy would have wide support.

Sequel risk

2019 was all about sequels for moviegoers with every one of the top ten grossing films a sequel or remake, with Disney’s Frozen 2 pulling in over $1 billion globally. 2020 may be about sequels for investors: U.S.-China “Phase 2” trade talks and Brexit’s “Stage 2” UK-European Union trade negotiations. There is some risk that these events could cause pressures to reemerge that could undermine the Eurozone’s improving economic momentum. But, if so, it would be more likely to take place near the end of the year given the year-end deadline for Brexit Stage 2 negotiators and Trump’s indication that he may wait until after the November election to push for a Phase 2 deal with China. In the meantime, the European economy and earnings may continue to rebound, potentially benefiting European stocks.